Private equity alternative liquidity: secondary transactions, GP led transactions, etc

Tuesday 4 July 2023

Thursday 30 March 2023

Session Chairs

Mike Carew, Kirkland & Ellis, Chicago

Thierry Lesage, Arendt & Medernach, Luxembourg


Morgan L Klinzig, Troutman Pepper, Philadelphia

Marcel Meier, Oberson Abels, Geneva

Bodo Bender, White & Case, Frankfurt

Ceinwen Rees, Macfarlanes, London

Jeroen Smits, Stibbe, Amsterdam


Lukas Aebi, Lenz & Staehelin, Zürich


Thierry Lesage began by distinguishing three types of secondary transactions: (1) limited partner (LP) secondary transactions; (2) direct secondary transactions; and (3) general partner (GP) led secondary transactions, where a fund's GP sells an asset of a fund to a continuation fund (CF) managed by the same GP.

Mike Carew explained that the panel would focus on the GP led CF transactions. The main economic rationale behind these transactions is enabling willing investors to continue exposure to well-performing assets, while allowing new investors into the CF. Private equity firms may use CF strategies to provide liquidity to selling LPs, to allow tax deferral for rolling LPs and to enable the GP to crystallise carried interest.

Thierry Lesage also discussed the handling of conflicts of interest between GPs, selling and rolling/reinvesting LPs, as well as the pricing and valuation of transferred assets.

Transaction structures

Mike Carew introduced two prevalent CF structures in the United States market.

The first transaction structure (disguised sale plus tax deferred rollover) involves the existing fund (EF) contributing the ‘continuation’ assets to the CF, followed by the distribution of CF units to its partners. New investors invest in the CF, which then uses the proceeds to redeem EF LPs who have elected to sell their interests.

The second transaction structure (fully taxable sale with after-tax reinvestments) involves reinvesting partners of the EF and new investors creating the CF and contributing cash. The CF uses the cash to acquire continuation assets from the EF, which then distributes the cash to its partners.

US tax considerations

Morgan L Klinzig explained that new investors will want to avoid the CF being classified as a continuation of the EF under the Internal Revenue Code (IRC) section 708, as they will not want any liability for the historic taxes of the EF. Where the CF is treated as a continuation of the EF, new investors will ask the partnership for a ‘push-out election’ (IRC section 6226), which would make the existing partners liable for their share of the historic tax.

With regards to transaction structure one, it is essential to avoid triggering IRC section 721(b), as a requalification of the CF as an investment company would prevent it for the rolling partners to achieve tax deferral on the contribution of the assets into the CF.

With regards to transaction structure two, the risk that the transaction may be recast as a partnership division and the topic of loss recognition under IRC section 267 should be considered.

For non-US selling or reinvesting LPs, the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) and effectively connected income (ECI) withholding is of relevance in case the CF acquires US real property interests (USRPIs) or assets generating ECI. Also, since 1 January 2023, a secondary ECI withholding obligation is placed on the CF in case the buyers fail to withhold. Withholding can be reduced by using respective certificates.

IRC section 754 allows for an adjustment of the inside cost basis to the outside cost basis for the new investors. CFs often agree to make IRC section 754 elections at the CF level and for controlled flow-through entities owned by the CF.

Lastly, the treatment of carried interest in CF transactions needs to be considered. The EF GP's carried interest is often crystallised in CF transactions and, then, either sold for cash (alongside the selling LPs) or rolled into the CF (alongside the rolling LPs). IRC section 1061 requires a three-year holding period for long-term capital gains treatment (instead of the normal one-year holding period). The new carried interest of the CF GP is typically taken on profits above the CF transaction value and therefore has a US$0 liquidation value at grant. CF GP members thus regularly file IRC section 83(b) elections to avoid tax consequences upon vesting of the CF GP interests.

United Kingdom tax considerations

Ceinwen Rees stated that CF transactions may trigger taxes at the level of portfolio companies transferred from the EF to the CF. Firstly, non-resident capital gains tax might be triggered if the portfolio company holds UK real estate. Second, the change in ownership might affect the use of loss carry-forwards of portfolio companies. Third, CF transactions might trigger management incentive plans, which then require analysis to determine whether a tax-free rollover for management is also available.

From a ‘buyside’ perspective, the BlackRock case (HMRC v BlackRock Holdco 5 LLC [2022] UKUT 199 (TCC)) has raised doubts as to whether interest paid on third party debt entered into by the CF might be deductible for UK tax purposes under the unallowable purpose rule, in particular if the number of rolling LP shareholders is high.

Concerning the investors, it should be possible for them to achieve a tax-free rollover with regards to the transfer of capital assets. The situation is less clear with regards to debt securities, where accrued interest needs to be dealt with.

At the level of the fund, the usual tax issues apply.

As to carried interest, the usual rules apply to CF transactions. With regards to carried interest in the EF, it is difficult to achieve a tax-free rollover. For carried interest in the new fund, the clock is reset for the applicable holding periods. As to valuation, the question is whether HM Revenue and Customs’ (HMRC) memorandum of understanding (agreed on 25 July 2003 between the Inland Revenue and the British Venture Capital Association) applies. In case of a single asset CF, it is likely that a high valuation for the carried interest will apply.

Swiss tax considerations

Marcel Meier explained that it is rare for private equity funds to be established in Switzerland and that Swiss funds have had limited success in practice. Funds in the form of limited partnerships are treated transparently for Swiss tax purposes.

Therefore, in case a Swiss portfolio company makes distributions to a fund, it would theoretically be possible for non-Swiss resident investors in the fund to claim a refund of their pro-rata share of Swiss withholding tax. In practice, however, such a refund faces multiple obstacles. For this reason, in order to apply Swiss double taxation agreements and to avoid the 35 per cent Swiss withholding tax on dividends, Swiss portfolio companies are usually acquired through Swiss or foreign based acquisition companies. The Swiss Federal Tax Administration analyses such structures according to tax treaty abuse considerations.

If Swiss portfolio companies are transferred in the context of CF transactions, it needs to be analysed as to whether the withholding tax position of the new shareholder is improved in comparison to the prior shareholder. If that is the case, future distributions by a Swiss portfolio company may continue to be subject to the withholding tax refund rate that applied to the prior shareholder under different anti-abuse regimes (old reserves practices, international transposition, international liquidation by proxy).

German tax considerations

Bodo Bender mentioned that the initial question from a German tax perspective is always the tax treatment of the funds. Typically, private equity funds organised as partnerships are fully disregarded for German tax purposes, meaning that each investor is treated as owning a pro-rata share of every asset (and liability) of the fund.

GP led secondary transactions are often structured as exit and reinvestment transactions. This leads to tax consequences for the reinvesting investors (insofar as they are not tax exempt).

Rollover structures can also be achieved and may be more tax efficient, in particular for individual investors in the EF. The transaction structuring is, however, usually more complex. Due to the tax transparency of funds organised as partnerships, the rolling investors keep their tax basis in the fund’s assets. No tax deferral is usually available to the extent of the investor’s (indirect) participation in the fund’s asset changes.

Dutch tax consideration

Jeroen Smits stated that, from a Dutch tax perspective, GP led secondary transactions are usually structured as an exit and reinvestment transaction and the capital gain realised from the transaction is recognised at the level of the EF (if structured as a Dutch Coöperatie, cooperative) or the investment holding company. In both cases, however, the gain is fully exempt from Dutch corporate income tax.

For the reinvesting shareholders, a rollover can be structured through the distribution of a note by the EF to the selling shareholders, which is subsequently contributed to the CF. Hence, investors either receive cash in the case of the selling of LPs or a note/cash in case of the reinvesting of LPs. Given the distribution character of the rollover, a carryover of the tax basis is difficult to achieve for reinvesting LPs and, thus, typically is not available for Dutch LPs.

In case a low tax jurisdiction (LTJ) is involved, the Dutch Tax Administration is prohibited from issuing an entity classification ruling on the fund structure. Therefore, in case of LTJ investors, it may not be possible to obtain a tax ruling. Furthermore, reverse hybrid mismatch rules (following the Dutch implementation of EU Anti-Tax Avoidance Directive (ATAD2)) may cause a Dutch limited partnership (commanditaire vennootschap, CV) to become subject to Dutch corporate income tax (CIT) and dividend withholding tax and, from 2024 onwards, distributions to LPs in a LTJ may become subject to the Dutch conditional withholding tax. The trend is to move from CV–cooperative structures to cooperative only structures.